The One Free Lunch Left for Investors

Jeremy Grantham's long awaited quarterly letter made the rounds earlier this week. Most reporters, including MoneyWatch's own Conrad de Aenlle, focused on the guru's sarcastic evisceration of Bernanke and Geithner and his gloomy outlook for the stock market in general. But buried in the letter was a rare (of late) positive review for one sector of the stock market. Quality growth stocks, said Grantham, chief investment officer of money manager GMO, are now so cheap compared to the more deeply indebted, less stable corners of the market that they amount to a "free lunch." The man who forecast the market bubbles of 2000 and 2007 does not use that term lightly.

Grantham isn't the only one to note the bargain pricing of high-quality growth stocks compared to the rest of the market. Morgan Stanley analysts Gerard Minack and Jason Todd wrote about it last month. As you can see from the chart below, stocks that got high quality ratings from Standard and Poor's have barely participated in the summer rally. The big gains were racked up by the seedier elements -- i.e., those deemed by S&P to have less stable and sustainable earnings. "The rally since March has been a risk rally," is the way that Grant Bowers, portfolio manager of Franklin Growth Opportunities fund (FGRAX) summed up the discrepancy in an interview at his office this week.

Diverging performance between quality growth stocks and other parts of the stock market is all part of a fairly standard cycle. Growth stocks can lag for periods of as long as seven years; then the cycle shifts and it's growth's turn again. Because they are more reliable, growth stocks usually trade at higher price-earnings multiples than the rest of the market. But at the moment, the average high-quality growth stock trades at no premium at all to the proletariat of the market. History would suggest that means the cycle is getting ready to turn.

What does this possibility mean to you? It means that you might want to put your next equity dollars into a growth fund or ETF. If you have both value and growth funds in your portfolio (and you do, don't you?), you might want to rebalance a bit of your holdings from the former into the latter, as long as you conduct the transaction in a 401(k) or IRA, where you won't get hit by capital gains taxes.

What it doesn't mean is that growth stocks will take off no matter what happens in the market. Growth stocks are stocks, after all. But if you're worried that the market may have gotten a little ahead of economic reality, quality stocks are what you'd want to own. And Morgan Stanley's Minack sees no reason to think history won't repeat. "We remain convinced that quality will handsomely outperform in a flat or down market," he said by email today. You could argue whether that's really a free lunch as Grantham says. But odds are, it's at least a blue plate special.